With the end of the year approaching, traders already are planning how to start the new year on the right foot by playing the so-called “January Effect.” Great — but what is it, and how can investors tap into it? And more than that, is there any merit to the idea? Glad you asked.

The January Effect(s)

Actually, there are three theories that generally are referred to as the January Effect.

The more-commonly understood one is the assumption that the tone set in the first month of the year often indicates how the market will perform during the following 11 months — a positive January means the market is on pace for a gainful year, and a bearish January paves the way for weakness through the following December. Ergo, keeping a watchful eye on how things shape up in January might help long-term investors navigate the rest of the year.

Another January Effect is the idea that small and beaten-down stocks tend to outperform larger and recently strong ones over the course of the first month of the year. Clearly, this is more of a trader’s approach, as the effect only lasts a month or so.

The third version of the January Effect is a variation on the second. It simply says that the first five trading days of the year are enough indication of what (and how) traders are thinking to set the tone for the year. In other words, if the first five days of 2012 are bullish, the whole year will be as well. If the first five days are bearish instead, well … that’s not encouraging.

Is there any truth to any of the axioms? Yes and no. So, before you bet the farm on one of the premises, you might want to know whether these January Effects have a fruitful history — or if they’re just more misguided assumptions.

Small Caps Versus Large Caps

While the historical numbers can vary from one researcher to the next, they all generally point in the same direction: Small caps usually do outperform large caps during the first month of the year.

For example, Bank of America Merrill Lynch strategist Steven G. DeSanctis has found that the Russell 2000 Small Cap Index has outperformed large caps more than 70% of the time since 1926. He also notes that January usually is the best month for small caps; they’ve averaged a gain of 4% in that month.

University of Kansas professors Mark Haug and Mark Hirschey broadly confirmed the idea, discovering that between 1927 and 2004, small-cap stocks outperformed large caps by an average of 2.5% in the first month of the calendar year.

Point being, the math supports the assumption. And for many investors, the historical results alone would be enough to make the bet. For other investors, though, the reason for the results still has to be clear. That’s where the strategy can hit a wall — it’s not clear why it happens.

There is a common theory, however.

That most common explanation doesn’t specifically apply to small caps, but also is geared toward the market’s weaker performers in the prior year (which in many ways have become de facto “small caps”). It simply suggests that investors sell off their biggest losers before the end of the calendar year for tax write-off purposes, then buy them back in the beginning of the year. Fund managers have been accused of doing the same so they don’t have to show a losing holding in their end-of-quarter reports.

There’s a less-favored explanation, too: Since annual bonuses tend to be paid in January, that inflow of extra cash is put into the market over the course of the month, boosting stocks. But again, it’s not a strongly supported idea.

‘As Goes January, So Goes the Year’

Since 1945, a bullish January preceded a bullish rest of the year more than 80% of the time — odds anyone would gladly take to Las Vegas. It gets even better on the bearish side of the table, though. Jeff Hirsch — publisher of the highly recommended Stock Trader’s Almanac — has concluded that every losing January since 1950 did indeed mark a flat-to-bearish year. Not bad.

The most common explanation is the obvious one: If traders are optimistic about the whole year, they’re likely to take positions as soon as possible. If they’re feeling pessimistic about it and were just looking to delay tax-based selling until the new year, that also will be reflected early on in the year.

And what about the “first five days” deal? That assumption doesn’t hold enough water to act upon.

History has shown that if the first five days of January are bullish, a little more than two-thirds of the time, that whole year will be a winner. Impressed? Don’t be. History also shows that if the first five days of January are bearish, the market moves higher that year about two-thirds of the time anyway. In other words, the predictive power of the “first five days” premise isn’t much better than a coin toss. The logic of it sure sounds good, though.

Bottom Line

As you can see, sometimes the assumptions are backed up by numbers, and sometimes they’re not. The data does generally support these January Effect theories. As such, they are worth following … cautiously. Two caveats are rarely discussed, however.

When the theories don’t work, they really don’t work — in a massively painful way. In other words, traders usually can’t afford to be on the “exception” side of the table, rare as they might be.

While the correlation between January’s performance and the rest of the year is high, that same statistical correlation applies to February’s performance, March’s performance and so on. If we’re in a bull market, we tend to see bullishness in most months, creating an overall bullish year. The same goes for bear markets. So don’t draw too much of a cause-effect conclusion. It’s a correlation, albeit a powerful one.

Regardless, nothing replaces old-fashioned common sense and just paying attention to the market.